Clients are often blind to market risk and typically don’t have accurate downside expectations—either too conservative or too reckless, leading to sub-optimal investment allocations.
Another challenge that clients face is how to feel about their portfolio returns. For example, would your client say a 5 percent return was good or bad? Knowing the risk involved in the return changes the way clients feel about their money. This is the basis of risk tolerance. Clients can’t make informed decisions about their money if they don’t have the entire picture.
Effectively estimating a client’s risk can help him avoid behavioral mistakes, significantly impacting his bottom line. I believe a solid risk discussion is the central element of behavioral coaching, which multiple studies have quantified as delivering Advisor’s Alpha upwards of 1.5 percent annually. Additionally, advisors should care about explaining risk, because helping your clients avoid the classic pitfalls that can destroy retirements builds a stronger, more trusting relationship.
How do you effectively estimate a client’s risk?
In order to properly estimate portfolio risk, you need to use a heavy-tailed risk model. To understand “heavy tails,” we have to start with “tails.” The standard bell curve graph that we see used for everything from test scores to potential returns is fat in the middle and very narrow at the edges, which are also known as the “tails.”
The bell curve is a representation of how often something happens (or should happen if used to project into the future). Its ranges are based on standard deviations, which are a measure of how often something that’s not the mean should happen. One standard deviation is about 68 percent of the time, two standard deviations is about 95 percent of the time and three standard deviations is about 99.5 percent of the time.
The problem with using this model of returns in finance is that it’s simply wrong. Extreme events happen far more frequently than a normal distribution would predict. Using the visual above, “heavy tails” is simply a recognition of this fact. A “heavy-tailed” model that more effectively represents the reality of financial market returns, looks narrower in the middle, but fatter in the tails (see below) of the returns distribution of a 60/40 portfolio:
The existence of heavy tails in market returns is what makes an advisor’s role as behavioral coach so important. Big swings in both directions—up and down—happen regularly. As a result, advisors need to ensure that they set realistic expectations about potential market changes. Recognizing that the range of what is normal for a given portfolio is considerably broader than being modeled by the old bell curve highlights the importance of using a more reasonable process for setting client expectations.
What do clients need to know about risk?
A well-equipped advisor can help clients “practice” for an inevitable downturn. New market risk software products, like SmartRisk, help advisors reasonably assess the downside risk of an investment portfolio and test the client’s retirement income plan to determine if the client likely would be faced with unacceptable changes in living standard. The beauty of a market at historical highs is that it’s a great opportunity to have this conversation with your clients. In the event a client can’t withstand the downside impact of their current investments, a good advisor can reposition them to a portfolio that is more aligned with their risk tolerance.
Portfolio risk has multiple dimensions; they’re fairly easy to explain. Be prepared to answer questions like these:
How much can this portfolio lose in a particular period?
Simply stated, answer this question with how much risk is in the portfolio—how much could it lose in a quarter or in a year. This question is a great launching point to discuss your client’s risk tolerance and discover whether or not their tolerance is in line with their actual portfolio risk. If not, you have an opportunity to make changes and save them from potential frustration and loss.
Am I diversified?
Diversification is achieved when the gains in certain holdings of your portfolio offset the losses of other holdings. It means that you don’t have all (or most) of your eggs in the same basket. Diversification is critical because it reduces the impact of (bad) luck and isolated events on the overall performance of your portfolio. Strangely enough, there are few good measures of diversification available that a client can actually understand.
How would this portfolio look through a historical crash?
Conducting a historical analysis of how the portfolio preformed during its worst peak-to-trough is a sensible way to explain to clients what could happen in a market crash. There’s no way to predict the future, but this is a completely appropriate way to make an educated assumption.
Having these conversations with your client now, while we’re in a bull market, will help you move prospects to the planning process and expand your relationship with current clients.
Joe Elsasser, CFP, is president of Covisum.